Why This Rally Will Continue

 |  Includes: DIA, IVV, KBE, SPY
by: Richard Graham

This rally has been interesting. Some say it is an example of efficient markets pricing in the fact that economic doomsday has passed. Others say it is nothing more than an example of “irrational exuberance.” Unfortunately, both are right. The “green shoots” and “less bad” economic data will eventually bear fruit, which will give the market a real reason to rally. Furthermore, firms will continue to beat low earnings estimates, which will provide the market the momentum it needs to continue its upward march.

The Green Shoots Will Turn into Plants

The main driver of this rally has been the so-called “green shoots,” or bright spots of economic data that have been released since the market’s March bottom. The market has taken data like the increasing unemployment rate or increasing jobless claims and rallied on it, basing its claim to rally on the fact that the data beats its estimates. This reaction is certainly irrational. Q2 GDP data shows that consumption is declining, and banks continue to increase write-downs on commercial real estate and consumer credit card loans. These economic indicators, however, do not phase the market; it continues to march on.

Eventually, though, the green shoots will turn into plants. And, that is what we will see in Q3: GDP growth is almost universally projected to be positive. That coupled with corporate earnings “beats” along with more “less bad” economic data should propel the market upward through Q3.

Corporate Earnings and Bank Stocks

Another recent driver of this rally has been corporate earnings. During this earnings season, 74% of companies have beaten earnings estimates. The reason for this is simple. Firms along with analysts gave ridiculously low earnings and revenue estimates. Firms’ cost cutting measures easily allowed them to beat these lowball estimates, which propelled the market higher and gave it confidence.

Additionally, in a recent WSJ editorial, Zachary Karabell raises a good point about the source of US corporate earnings. He points out that most firms are not solely reliant on US economic growth. Even if the US continues sluggish growth, firms will reach outside the US to generate the growth and revenues necessary to keep up with earnings expectations. It seems that the fates of the stock market and the US economy have begun to diverge.

One check against the market’s exuberant joy during earnings season should have been bank stocks. These firms still hold a large amount of deteriorating commercial real estate and consumer credit card loans. Additionally, they still possess a large amount of various illiquid asset backed securities. Banks and Congress, however, prevented these factors from having any real effect by pressuring the change of FASB Rule 157. Because banks can now estimate the fair value of their illiquid (and deteriorating) assets instead of relying on market prices, they have successfully finagled their balance sheets into looking healthier than they actually are. That, coupled with large trading profits, easily overshadows any impending problems for banks. Because banks were the main cause of this crisis, their recovery is crucial to market confidence. And, because their profitability and health does not seem to be threatened, banks will continue to infuse the market with confidence.

Sluggish Recovery

One argument most bears levy against bulls is that economic recovery will be sluggish. It will be marked by high unemployment, low consumer spending, increased savings, and even high inflation. These claims are true, however, the market has already factored them into stock prices. When the front cover of Newsweek says that the recovery will be sluggish, it is safe to say that everyone knows the recovery will be sluggish, and that obviously includes the stock market. Additionally, as the sluggish recovery continues, firms and analysts will continue to produce low earnings estimates that will continue to be beaten, propelling stocks higher.